Technical / Valuation
CAPM: The Price of Taking Risk
Master CAPM for IB interviews: formula, beta, equity risk premium, and why systematic risk is the only risk that gets compensated.
"Risk comes from not knowing what you're doing." — Warren Buffett
Concept
The Capital Asset Pricing Model (CAPM) calculates the expected return on an equity investment. It says your required return equals the risk-free rate plus a premium for bearing systematic (market) risk. The premium is your stock's sensitivity to the market (beta) multiplied by the market risk premium. It's the workhorse for calculating cost of equity in DCF valuations.
Intuition
CAPM's core logic: diversification kills idiosyncratic risk, but you can't diversify away the market itself. If you hold 30+ stocks, company-specific disasters wash out. What remains is exposure to the overall economy—recessions, rate shocks, systemic crises. Since you can't escape this systematic risk, the market compensates you for bearing it. Beta quantifies your exposure. Higher beta = more market sensitivity = higher required return. CAPM is just asking: "How much of your returns come from the market, and what premium do you demand for that?"
Components
Risk-Free Rate
What It Is
The return on a theoretically zero-risk investment. In practice, the 10-year U.S. Treasury yield is the standard proxy for dollar-denominated valuations.
How to Calculate It
Look it up. Pull the current yield on the 10-year Treasury. For non-U.S. companies, use the sovereign bond yield in the local currency, or use U.S. rates and adjust for country risk separately.
Key Consideration
Match the duration to your flows. A 10-year rate works for most DCFs. For short-term projects, a 2-year Treasury might be appropriate. Never use a 30-day T-bill for a perpetuity .
Interview Script
CAPM calculates the cost of equity as the risk-free rate plus beta times the market risk premium. The logic is that diversification eliminates company-specific risk, but you can't diversify away exposure to the overall market—so investors demand compensation for that systematic risk. Beta measures how sensitive a stock is to market movements, so higher beta means higher required return.